The crypto world is happy about the merger. Here is the real story.
Forget financial performance and forget the firehose of metrics regularly pumped out by the cryptocurrency industry. Ever since cryptocurrencies captured the imagination of investors a few years ago, the market has been driven by stories, not data.
First came the narrative that Bitcoin was destined to become a new form of money in a digital global economy. Then there was the argument that decentralized finance, or DeFi, would sideline banks and the rest of the old guard and give consumers better ways to manage their assets.
Now comes the last story. It’s called the Merger, and while it may sound like the title of the latest Netflix sci-fi series, it’s actually a sweeping redesign of the blockchain network that underpins Ethereum, the most valuable cryptocurrency after Bitcoin. Like most things in crypto, the merger is mysterious and technical. And yet it presents institutional investors with a simple question: Will this development finally demonstrate the utility of cryptocurrency — or is it just another dose of hype?
There is a lot at stake. The cryptocurrency market has lost more than half of its value this year and has been rocked by the failures of some major businesses, including Celsius and Terra, which evaporated more than $60 billion in market value over a few days in May. Meanwhile, US authorities are sanctioning popular platforms for alleged money laundering as part of a broad crackdown. The bad news has plunged the industry into its worst crisis of confidence since the 2018 crash, leaving even seasoned crypto figures in a deep funk.
“The window of opportunity for DeFi to prove its worth … to be considered a public, neutral financial aid rather than regulated like banks has now closed,” Rune Christensen, founder of MakerDAO, a leading crypto lender, said in a recent blog post. “DeFi failed to deliver anything of real value, and the massive crashes of Terra, Celsius, etc. destroyed its mainstream image.”
The merger could change all that. At least that’s the hope.
Ahead of the launch on 14 September at 9:30 p.m. ET, crypto social media channels have been abuzz with anticipation that the upgrade will kickstart a glorious new period of mass market adoption. Most excitingly, the change is meant to erase Ethereum’s carbon footprint and make it a green, ESG-worthy digital asset, unlike Bitcoin, which consumes as much electricity annually as the country of Pakistan. Although the Federal Reserve’s interest rate hikes have spurred investors to take risk off the table, Ethereum’s token, Ether, has risen 39 percent in the third quarter, compared to a 7 percent drop in Bitcoin’s price.
“This is the most significant catalyst in crypto history in terms of size,” Travis Kling, founder and chief investment officer of Ikigai Asset Management, a crypto investment firm, said in a recent podcast. “But there’s a lot of risk that goes into this merger in terms of price, technical design risk, technical implementation risk, hack risk, illiquidity risk. . . . There’s a lot of risk.”
Now is the moment for Ethereum’s backers to strengthen the value of their network, and cryptocurrencies as a whole. But what exactly is the merger?
In a nutshell, the upgrade changes the way Ethereum processes transactions and adds data to its ledger, or blockchain. For the past seven years, Ethereum has used the same approach as Bitcoin. Called proof-of-work, the process involves cryptocurrency miners competing to solve complex mathematical problems. The winners get to add blocks of data to the chain and harvest Ether as a reward. Because this is a race, miners utilize as much computing power as possible. That’s why these outfits run huge server farms in China, Kazakhstan and the US, the countries that dominate crypto mining. More than three-quarters of China’s electricity comes from burning fossil fuels, according to the Center for Strategic and International Studies.
Now, Ethereum is switching to an alternative way of maintaining its blockchain, called proof-of-stake. Instead of mining, the approach relies on so-called validators to stake their Ether tokens into pools and collaborate to evaluate and add new blocks of data to the network. The upgrade is called Merge because it will merge Ethereum’s main network with the Beacon Chain, a proof-of-stake system developers have used to test the technology.
Major upgrades are meant to fix major issues, and Ethereum has been hit by a number of problems as it has grown in popularity. First, Ethereum has struggled to cope with the demand to process financial transactions as a number of other crypto platforms have piggybacked on the network. Ethereum can only handle a measly 15 transactions per second, compared to more than 2,300 at Solana, one of a slew of potential Ethereum killers that have emerged in the past year or two. Meanwhile, Visa, the global credit card and payments giant, says it is capable of processing 65,000 transactions per second, but in practice it handles around 1,700.
Ethereum is also expensive to use. The average transaction cost on the network has run between $2 and $5 since early August, and the level rose to more than $30 earlier this year, according to Messari, a crypto data provider. It is simply too expensive to win over regular users. By comparison, Solana transactions cost only 25 thousandths of a cent. Given that DeFi is meant to give consumers a cheaper and more efficient way to manage their money, Ethereum’s limitations are a deal-breaker. And this is a key reason why investors continue to view Ether as a speculative asset rather than one that reflects real business value. Its long-term prospects are very unclear.
It’s no wonder the merger has cryptocurrency fans so excited. The idea is that the move to proof-of-stake will solve Ethereum’s problems in one fell swoop. After all, Solana uses a variant of the proof-of-stake approach to achieve high speeds and low transaction costs. And so do a bunch of other blockchain networks, including Cardano and Polkadot, both of which were set up by the co-founders of Ethereum.
But here’s the kicker: The merger won’t make Ethereum more efficient, at least not yet. That’s a misunderstanding, says the Ethereum Foundation, the Switzerland-based organization that manages the network. The merger is not designed to expand the network’s capacity, so fees and transaction speeds will remain largely the same. The big change will be a 99.95 percent reduction in the Ethereum blockchain’s energy consumption, the foundation says.
That is no small achievement. By ditching cryptomining, Ethereum could become a prime ESG candidate for responsible investors looking for green cryptoassets.
“The reduction in spending is a huge improvement,” says Timo Lehes, co-founder of Swarm, a Berlin-based crypto exchange. “Whether institutions now classify Ether as an ESG asset depends on criteria. If energy efficiency is part of a company’s ESG criteria, Ethereum 2.0 will undoubtedly fit the bill.”
Still, the merger is bound to separate the cryptocurrency from its older, carbon-spewing sibling Bitcoin.
Make no mistake, decoupling from Bitcoin has been the dream of Ethereum supporters for the better part of a decade. It drives them crazy that Ethereum continues to be with Bitcoin. Designed to be a global currency free of interference from central banks, Bitcoin has proven anything but. Over the past year, the token has completely failed to be a hedge against inflation and interest rate policy – a core value proposition. Bitcoin moves in tandem with the stock market, which begs the question: What’s the point of investing in it?
Ethereum’s developers, meanwhile, are still working on producing software that supports all kinds of applications and smart contracts, programs that automate transactions and agreements. Think of it as an operating system for crypto. While mass market acceptance still looks quixotic, the Ethereum community is committed to building technology that can be valued and judged as a business.
This is just the first phase of Ethereum’s narrative, as Vitalik Buterin, the 28-year-old co-founder and primary architect of Ethereum, pointed out at a conference in Paris last month. He told the crowd that Ethereum was only about 40 percent complete. Buterin also said the merger would be followed by at least four more phases of upgrading and expansion, called the Surge, the Verge, the Purge and the Splurge.
Stupid? Yes maybe. Still, Buterin assured the room that Ethereum would get to a point where it could process 100,000 transactions per second. “At the end of this roadmap, Ethereum will be a much more scalable system,” he said.
There’s little doubt that the merger will be anticlimactic when it goes live on September 14. Traders are likely driving up the price of Ether to capitalize on the anticipation. When you compare the arc of Ethereum’s narrative with other technological breakthroughs – the browser, broadband, streaming, fintech – it’s clear that the first act of this story is still well underway. The merger will be a test, but by no means the resolution.
